Line of Credit vs Term Loan - Is One Better Than The Other?
Business owners ask us all the time; when should I choose a business line of credit as opposed to a term loan? Every instance (like every company) has differences, but in general, the guideline below should help answer that burning question.
Term loan: Term loans are the kind of business loans work best for long-term investments. For instance, if you’re buying capital equipment or other fixed assets that will take several years to pay off, buying a business or doing construction, borrowing a lump sum of cash through a term loan is your best bet.
In addition, term loans are typically used for a specific purpose. Much like a personal loan, in order to get the loan you’ll need to show exactly why you need to borrow the money (what you plan to use the money for and how that will help your business increase sales and profits). If your financial projections convince lenders that these changes will increase your sales and profits, the lender will feel confident that your business will be able to make the repayment.
Here are some situations where you might use a term loan:
You own a pizza restaurant and want to expand into a larger space that just became available next door. You also want to add two wood-burning pizza ovens so you can serve upscale, Neapolitan-style pizzas (and charge more). The expansion and shift in positioning will take a while to pay off, and the pizza ovens have a usable life of 10 years. Therefore, it’s to your advantage to stretch out the repayment to a long-term loan of 10 years.
You own a graphic design business and need to buy new computers for your staff of 30. Typically computers have a life of about three years, so a three-year term loan would be appropriate.
The longer you’ve been in business, the easier it will be to get a term loan, as banks want to see a track record of success.
Business line of credit: A business equity line of credit is sometimes called an operating line of credit, because its purpose is to help finance ongoing operating expenses. Think of a line of credit, whether a secured or unsecured loan, as an insurance policy providing a cushion of cash when you need it. That’s why the best time to apply for a business line of credit as a borrower is before you need it—in order to get an unsecured line of credit, you need to prove that your business has healthy cash flow.
Business lines of credit are best for short-term financing needs, such as payroll, seasonal expenses, unexpected payments or temporary cash flow shortages. Missed payments on a line of credit can result in a significant increase in the interest rate.
Here are some situations where you might use a line of credit:
You own a landscaping business and have just completed several projects. You have a huge chunk of receivables due in a week—but you need to make payroll for your 20 employees in two days, and don’t have the cash on hand. You could use the line of credit to cover payroll, then pay it back as soon as your receivables come in.
You own a business selling fashion accessories from a kiosk, and a particular style of sunglasses is selling like crazy. You need to order more and your supplier is offering a great deal, but requires C.O.D. Use the line of credit to pay for the sunglasses, then pay it back as you sell them.
Be sure not to tie up your business equity line of credit paying for long-term investments, or you won’t have access to it in an emergency, limiting your flexibility—which is the whole point of a line of credit.
Working with an experienced professional like Clover Capital can not only help business owners in deciding between the two options, but they can also work hard to make sure the most cost-effective option is delivered.
To learn more or schedule an appointment with an adviser, visit www.clovercapital.org today.
